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Pharma Stock Outlook: Let's Make a Deal – Zacks Analyst Interviews

2014 turned out to be one of the most active years in the pharma sector where mergers and acquisitions (M&As) and licensing agreements are concerned. While tax inversion deals were being actively pursued earlier, these cross-border deals lost their luster considering new rules imposed by the Treasury Department.

Deal-Making Frenzy Showing No Signs of Slowing Down

Nevertheless, M&As continue to play a major role in the pharma and biotech sector and are not showing any signs of slowing down. AbbVie’s (ABBV) $21 billion acquisition agreement with Pharmacyclics (PCYC) is one of the biggest deals to be announced in recent times. The deal goes to show that lofty valuations will not deter large companies from pursuing acquisitions to boost their pipelines and product portfolios. Other major deals include the ones involving Actavis (ACT) – Allergan (AGN), Shire (SHPG)-NPS Pharmaceuticals, Endo (ENDP) – Auxilium, and Pfizer (PFE)-Hospira (HSP). Salix (SLXP) is currently being wooed by both Valeant (VRX) and Endo.

Meanwhile, we expect small bolt-on acquisitions to continue. In-licensing activities and collaborations for the development of pipeline candidates have also increased significantly. Several pharma companies are focusing on in-licensing mid-to-late stage pipeline candidates that look promising, instead of developing a product from scratch, which involves a lot of funds and time.

Small biotech companies are open to such deals – most of these companies find it challenging to raise cash, thereby making it difficult for them to survive and continue with the development of promising pipeline candidates. Therefore, it makes sense for them to seek deals with pharma companies sitting on huge piles of cash.

We recommend biotech stocks that have attractive pipeline candidates or technology that can be used for the development of novel therapeutics. Therapeutic areas attracting a lot of interest include central nervous system disorders, diabetes and immunology/inflammation.

The hepatitis C virus (HCV) market is also attracting a lot of attention. Another lucrative area is immuno-oncology as these therapies have the potential to change the treatment paradigm for cancer — they basically use the natural capability of the patient’s own immune system to fight the cancer. Major players in this field include Bristol-Myers (BMY), AstraZeneca (AZN), Merck (MRK) and Roche (RHHBY). Deals targeting immuno-oncology are being inked by companies like Pfizer, Merck KGaA (MKGAF), Bristol-Myers, AstraZeneca and Incyte (INCY).

Another trend witnessed recently is the divestment of non-core business segments. Companies like Pfizer, Abbott (ABT), UCB (UCBJF), Novartis (NVS), GlaxoSmithKline (GSK) and AstraZeneca have all been a part of this trend. The monetization of non-core assets allows these companies to focus on their areas of expertise.

Restructuring activities are also gaining momentum as large pharma companies look to cut costs and streamline operations. Most of these companies like Allergan, Merck, Novartis, Eli Lilly (LLY), Shire and Sanofi (SNY) are re-evaluating their pipelines and discontinuing programs with an unfavorable risk-benefit profile.

Products with Blockbuster Potential Gain Approval

Several important product approvals as well as label expansions were gained last year. Gilead strengthened its position in the HCV market further with its combination treatment, Harvoni, gaining FDA approval. Harvoni is expected to bring in multi-billion dollar sales for Gilead.

The highly lucrative obesity market got a new player with Orexigen’s (OREX) Contrave gaining FDA approval. Meanwhile, it proved to be third time lucky for MannKind (MNKD) with the company finally gaining approval for diabetes product, Afrezza.

With the FDA approving the first biosimilar in the U.S. (Zarxio, a biosimilar version of Amgen’s blockbuster drug, Neupogen), the floodgates have opened. While biosimilars have been available in the EU for quite a while, there was no regulatory pathway for biosimilars in the U.S.

Biosimilars should cut healthcare costs and provide a large number of patients with access to much needed biologic treatments. According to information provided by Express Scripts (ESRX), about $250 billion could be saved in the next decade (2014 – 2024) if biosimilars for 11 products including Neupogen, Avastin, Epogen, Humira, Neulasta, Remicade and Rituxan are approved. According to the company, Neupogen biosimilars alone represent potential savings of about $5.7 billion.

However, at present, there is low visibility on the pricing of biosimilars in the U.S. Unlike generics, which are sometimes priced at even a 90% discount to the branded drug, biosimilars are usually sold at a 20%-30% discount to the price of the reference drug. So, it could be a while before biosimilar sales actually pick up and meet industry expectations.

However, while higher demand for medicines, government initiatives for healthcare, new patient population and increasing use of generics should help drive demand, we point out that emerging markets are also not immune to genericization.

Earnings Trends

The Q4 earnings season is over for the medical sector. While the earnings “beat ratio” (percentage of companies coming out with positive surprises) was 81.1%, the revenue “beat ratio” was 69.8%. Total earnings grew 23.9% compared to 15.5% in 3Q, while total revenue grew 11.9% in the quarter compared to 12.1% in 3Q.

Looking at consensus earnings expectations for 1Q, earnings are expected to grow 10.5% and revenues 9%. While results will be affected by negative currency movement, new products should start contributing significantly to results and increased pipeline visibility and appropriate utilization of cash should increase confidence in the sector.

Overall, 2015 earnings are expected to grow 9.7% and revenues 9.6%. For a detailed look at the earnings outlook for the Medical and other sectors, please check our Zacks Earnings Trends report.

Zacks Industry Rank

Within the Zacks Industry classification, pharma and biotech are broadly grouped into the Medical sector (one of 16 Zacks sectors) and further sub-divided into four industries at the expanded level: large-cap pharma, med-biomed/gene, med-drugs and med-generic drugs.

We rank all the 260-plus industries in the 16 Zacks sectors based on the earnings outlook and fundamental strength of the constituent companies in each industry. To learn more, visit: About Zacks Industry Rank.

As a point of reference, the outlook for industries with Zacks Industry Rank #88 and lower is ‘Positive,’ between #89 and #176 is ‘Neutral’ and #177 and higher is ‘Negative.’

The Zacks Industry Rank for large-cap pharma is #192, med-biomed/gene is #75, med-drugs is #106, while med-generic drugs is #95. Analyzing the Zacks Industry Rank for different medical segments, it is obvious that the outlook is Positive for med-biomed/gene, Neutral for med-generic drugs and med-drugs and Negative for large-cap pharma stocks.

OPPORTUNITIES

While EU austerity measures, negative currency impact and pricing pressure remain headwinds, the pharma industry is out of the worst of its genericization phase. Many companies, which had faced generic headwinds in the last couple of years, should continue to see a sustained improvement in results this year. Cost-cutting, downsizing, emerging markets and new products should support growth.

Among pharma stocks, companies like Salix and Valeant carry favorable Zacks Ranks. Valeant, a Zacks Rank #2 (Buy) stock, has been in the news given its acquisition strategy. After failing to acquire Allergan, Valeant is currently looking to acquire Salix, a Zacks Rank #1 (Strong Buy) stock.

In the biotech space, we are positive on Isis (ISIS), Geron (GERN), Acorda (ACOR) and Osiris (OSIR) among others. While Acorda is a Zacks Rank #1 (Strong Buy) stock, the others carry a Zacks Rank #2.

Among generic companies, Akorn (AKRX) and Actavis look well-positioned. While Akorn is a Zacks Rank #1 stock, Actavis carries a Zacks Rank #2. With the upcoming Allergan acquisition, Actavis, which was previously known for its strong presence in the generics market, will find itself in the company of the top 10 pharmaceutical companies across the world based on sales.

WEAKNESSES

We recommend avoiding names that offer little growth or opportunity for a take-out. These include companies which are developing drugs that are likely to face regulatory hurdles.

Large-cap pharma companies that currently carry a Zacks Rank #4 (Sell) include Sanofi, Bayer (BAYRY), Novartis, Novo Nordisk (NVO) and Roche. Among biotech stocks, companies like Regeneron (REGN), Arena (ARNA), Puma (PBYI) and Alkermes (ALKS) are Zacks Rank #4 stocks.Want the latest recommendations from Zacks Investment Research? Today, you can download 7 Best Stocks for the Next 30 Days. Click to get this free report